ERSOP Plans as a Financing Alternative for Start-ups

Published Categorized as Federal Income Tax, Retirement Accounts, Tax
Entrepreneur Rollover Stock Purchase Plans
Entrepreneur Rollover Stock Purchase Plans

Starting a new business can be an exciting and challenging endeavor, but financing the venture can often prove to be a significant obstacle. Traditional lenders typically require a business to be operational for at least a year before they will consider providing small business loans. Meanwhile, venture capitalists often reject the majority of start-up proposals or demand a substantial ownership stake in the business. As a result, many entrepreneurs are exploring alternative financing options, such as Entrepreneur Rollover Stock Purchase (“ERSOP”) plans and Rollover as Business Start-up (“ROBS”) plans. If properly executed, there are some significant tax savings that can be realized from these arrangements.

Understanding ERSOP Plans

An ERSOP plan allows entrepreneurs to utilize their existing 401(k), IRA, or other qualified retirement plans to fund their start-ups. The process involves the following steps:

  1. Establish a legal entity.
  2. Obtain a taxpayer identification number and checking account for the entity.
  3. Set up a trust, secure a taxpayer identification number, and open a checking account for the trust.
  4. Apply for a determination letter from the IRS, confirming that the trust qualifies as an everyday employee stock option purchase plan (“ESOP”).
  5. Roll over the entrepreneur’s retirement accounts to the trust checking account, and then to the entity checking account.
  6. Transfer entity stock into the trust.

Once completed, the funds are available in the business checking account, and the business stock is held in the ESOP.

ERSOP Promotion and Use

Financial planners and large accounting firms are often familiar with ERSOP plans, but they rarely actively recommend them. Instead, professionals facilitating franchise business transfers seem to be driving the promotion of ERSOPs. Numerous online businesses claim to specialize in handling these types of transactions, such as

Potential Risks and Drawbacks

While ERSOPs can be an attractive alternative financing option, there are several notable risks and drawbacks associated with using retirement accounts to fund speculative business ventures:

  • Increased vulnerability due to diminished government safety nets and heightened regulations.
  • Violation of self-dealing rules required for ESOPs.
  • Additional accounting and compliance requirements and costs.
  • Limitations on future business structuring due to near-permanent stock ownership arrangements.
  • Potential constraints on entrepreneurs’ rights if the business fails or if they wish to sell the business in the future.
  • Susceptibility to future legal changes.

When an ERSOP Plan May Be Suitable

Despite the potential drawbacks, ERSOP plans may still be appropriate in specific situations. Entrepreneurs who are planning to use other risky financing methods (such as credit card debt) and are fully aware of the consequences and requirements may be viable candidates for an ERSOP plan. This financing option may be particularly appealing for those with significant illiquid wealth held outside their retirement accounts.

Future of ERSOPs

Tight money supply and stringent underwriting mandates from Congress are likely to fuel the popularity of ERSOPs and other alternative financing arrangements in the short term. However, in the long run, ERSOPs may either be legislated out of existence or surpassed by simpler financing alternatives.

Rollover as Business Start-up (ROBS) Plans

Similar to ERSOPs, ROBS plans are arrangements in which prospective business owners use their retirement funds to pay for new business start-up costs. The ROBS plan involves rolling over existing retirement funds into the ROBS plan in a tax-free transaction, which then uses the assets to purchase the stock of the new C Corporation business.

According to the IRS, promoters aggressively market ROBS arrangements to prospective business owners, often seeking a favorable determination letter (“DL”) from the IRS to assure clients that the arrangement is approved. However, DLs do not provide protection against incorrect application of the plan’s terms or discriminatory operation of the plan, which can lead to disqualification and adverse tax consequences for the plan’s sponsor and participants.

Employee Plans (EP) ROBS Project

In 2009, the EP initiated a ROBS project whereby it audited plans to:

  1. Define traits of compliant versus noncompliant ROBS plans.
  2. Identify noncompliant ROBS plans and take corrective action.
  3. Design compliance strategies based on identified issues and trends (e.g., Employee Plans Compliance Resolution System, Fix-It Guides, web-based information, newsletters, speeches).

Compliance checks focused on companies that sponsored a plan and received a DL but did not file required forms, such as Form 5500, Form 5500-EZ, or Form 1120. The contact letter to plan sponsors asked questions about the plan’s recordkeeping and information reporting requirements, participant information, stock valuation, business information, and the reason for not filing the required forms.

The IRS’s ROBS Project Findings

The ROBS Project found that while some businesses achieved success, most ROBS businesses either failed or were on the road to failure, with high rates of bankruptcy, liens, and corporate dissolutions. Many individuals who started ROBS plans lost their retirement savings and their businesses. Some cases involved large recurring promoter fees or legal issues.

Many ROBS sponsors were unaware that a qualified plan is a separate entity with its own set of requirements. Some promoters incorrectly advised sponsors that they did not have an annual return filing requirement due to a special exception for ‘one-participant’ plans, which does not apply to ROBS plans.

Specific Problems with ROBS

ROBS plans could face issues related to:

  1. Amending the plan after purchasing the employer stock with rollover funds, which could result in violations of coverage, discrimination, and benefits, rights, and features requirements.
  2. Promoter fees.
  3. Valuation of assets.
  4. Failure to issue a Form 1099-R when the assets are rolled over into the ROBS plan.

The Takeaway

Both ERSOP and ROBS plans offer alternative financing options for start-up businesses. However, entrepreneurs should carefully consider the potential risks, drawbacks, and compliance requirements associated with these financing methods before pursuing them. In some cases, these options can provide much-needed funding to launch a successful venture, but they also come with the possibility of losing retirement savings and facing legal complications.

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